Guest Author Katherine Pendrill, the Content Marketing Specialist at OpenDigits, explains the connection between accounts receivable and bookkeeping.
Anyone running a business knows the importance of keeping an eye on accounts receivable (A/R). This is the money owed by customers for goods or services that have been delivered or used on credit, but not yet paid for. In other words, A/R is money owed, and when you’re running a business on a tight budget, the fewer outstanding invoices, the better.
However, when most business owners think of managing A/R, they think of it as a cash flow issue. The faster customers pay their invoices, the more cash a company has on hand. While managing A/R—whether it’s on your own or with a virtual A/R staffing solution such as InvoiceCare—is certainly important for increasing cash flow, few businesses think about how A/R can also impact their bookkeeping.
Although bookkeeping seems like it is cut and dried, it is actually based on a number of assumptions that can affect the information recorded and presented. A/R is one of those key factors that can impact the information that a bookkeeper has and the assumptions they make based on that information. When your A/R is properly managed, it can make your bookkeeping more accurate and provide a clearer picture of the overall financial health of your business. However, poorly managed A/R has the opposite effect. As a result, it’s important to fully understand the connection between A/R and your bookkeeping in order to make the smartest financial decisions for your business.
The Impact on Your Financial Statements
As a business owner, financial statements are like a snapshot of how your business is doing. Armed with this information, you make certain decisions about the next moves your company will make. However, A/R can make some of these oh-so-important financial statements a bit misleading.
The effect of A/R on revenue depends on what type of accounting convention your bookkeeper uses—be it cash or accrual-basis accounting. If your bookkeeper uses the cash method, transactions are only recorded as a sale when a customer actually pays you. Therefore, A/R does not affect your net income.
However, the accrual method of accounting (which is frequently used by startups), records transactions as sales no matter when a customer pays. Using this method, A/R is listed as revenue on Income Statements. This means that greater receivables are actually seen as positive on Income Statements. However, the problem with this method is that an increase in receivables can cause current-period revenue to become overstated, which can be misleading given that money has not yet been collected. This is problematic because it may skew an owner’s understanding of their current financial picture if they are only looking at their Income Statement.
This issue can easily be solved by properly managing your A/R. When a company’s A/R is in order, the imbalance between accounts and receivables is lessened. This means that your Income Statement will more accurately reflect the company’s net income in a given period and there is less risk that revenue will be overstated.
When you’re a business owner, you’ve always got one eye on the future. You’re constantly adjusting your budget to make sure that every dollar that comes in is spent in the right way.
This is where receivables come in. Receivables represent the current earned income that will be received in the future. While this is a bit backward from a revenue perspective, it is forward-looking from a cash-flow perspective. For bookkeepers, receivables are current assets that reveal a company's liquidity or its ability to cover short-term obligations. As a result, A/R impacts the way budgets are created. For instance, if a bookkeeper expects cash flow from receivables to arrive within 30 days of the invoice being sent, they will budget expenses accordingly. The problem is, if a budget is created this way and then those invoices aren’t paid as expected, the budget can quickly become underfunded.
Running out of money is a business owner’s worst nightmare, which is why properly managed A/R is so important when it comes to accurate budget-making. If invoices are routinely paid on time, for the right amount, there is less risk of budgets being underfunded. In other words, having A/R in order is necessary for bookkeepers to set reliable budgets.
Securing Investments and Loans
When a startup or a small business begins to grow, funding is a top concern. Whether it’s raising money from high-profile investors or securing a loan from the local bank, having the right financial information is key to securing vital funding.
A/R comes into play during these fundraising rounds or loan applications because banks, lenders, and investors will be scrutinizing a company’s books in order to know whether a company is eligible for funding. If you use the accrual accounting method and don’t pay close attention to your A/R, both revenue and assets could become suspect. This is because, while A/R is listed as revenue on an Income Statement, it is also an asset—something a company owns or controls—on the Balance Sheet because there is a legal obligation for customers to pay their debts. However, A/R is not guaranteed to turn into cash. When A/R is overstated, the short term assets go up, resulting in an unhealthy Balance Sheet.
From a funding perspective, the A/R turnover ratio reveals how effective a company is at collecting its credited sales. if a company’s A/R turnover ratio is declining, this could indicate to lenders or investors that a company has lax practices when it comes to collecting its debt, or that the company is giving customers too long to pay. In fact, if your company has a line of credit, you may be required by banking covenants to keep A/R below a certain limit.
Therefore, A/R is an important metric that banks, lenders, and investors will likely hone in on when combing through a business’ books. When A/R is properly managed, this indicates to investors and lenders that a company’s receivables will likely turn into cash that can be used to pay back an investment or loan. As a result, it’s important for businesses to properly manage their A/R to keep the books in good shape and secure the funding needed for growth.
As noted, you don’t need to tell a business owner that A/R affects their cash flow—they’re well aware. But while most business owners know the basics of how A/R affects their cash flow, they may not have considered how it impacts their bookkeeping.
Whether the person doing your books uses the cash or accrual method, A/R affects cash flow because money cannot be spent if it has not yet been received. If A/R turnover time increases, your business could be at risk of experiencing a negative cash flow, even if it looks like you’ve earned sufficient revenue to cover your expenses and turn a profit. In other words, if customers take longer and longer to pay for the products or services they’ve purchased, you’ll likely find yourself running short on cash to cover day-to-day operations. Over time, poor cash flow can cause your long-term revenue to decline.
As a result, managing cash flow is intimately linked to the management of your A/R. In this case, it’s important to consider your overall cash flow needs and make sure that the balance does not tip too far in the favor of receivables. This will help you determine how much credit to extend to customers to ensure that you always have enough cash coming in to cover things like inventory and paying your employees. In other words, working to decrease your A/R turnover time will give your bookkeeper a more reliable picture of your cash flow situation
At the end of the day, it’s clear that managing A/R is more than just a matter of keeping the cash flowing. A/R has a major impact on the information that your bookkeeper has available to paint a picture of the overall financial health of your business. Of course, A/R is just one piece of the bookkeeping puzzle. To ensure your books are fully reconciled and tax-ready, consider using a full-service bookkeeping solution like OpenDigits to do the heavy lifting for you.
Katherine Pendrill is the Content Marketing Specialist at OpenDigits, a cloud bookkeeping solution for startups. By combining industry-leading software with the expertise of real accountants, OpenDigits takes care of the bookkeeping so that startup founders can focus on scaling their business.